Interest Rates and the Fiscal Outlook

A great debate is breaking out over concerns for our growing debt, and it is centered around interest rates on Treasury securities.  A fear held by many, including CRFB, is that growing deficits will cause investors to demand a higher risk premium on Treasuries, causing interest rates to rise and hurting the overall economy as a result.  Commentators on both sides of the debate have used interest rates as proof of investors' level of concern regarding the fiscal outlook. 

Those who are less concerned say the proof is in the pudding: even with record deficits, both short-term and long-term rates have been relatively low, indicating that investors are not worried about default risk on U.S. debt or inflation risk.  However, as Steve Randy Waldman pointed out, these low rates have been largely due to the Federal Reserve's historically low rates.  

A better measure to use to gauge investor concerns is the yield curve.  Waldman explains that long term rates are determined by adding the short term rate to a "term premium", which accounts for future interest rate and inflation risk (presumably default risk as well).  The yield curve, which subtracts a short term Treasury rate from a longer term rate (normally 2 years/10 years and 3 months/30 years), shows this term premium and therefore accounts for investor concern for future inflation and possible default.  The results are clear:

"Since the financial crisis began, the market determined part of the Treasury's cost of borrowing has steadily risen, except for a brief, sharp flight to safety around the fall of 2008.  Investors have been demanding greater compensation for bearing interest rate and inflation risk, but that has been masked by the monetary-policy induced drop in short-term rates."

Richard Fisher, the President of the Federal Reserve Bank of Dallas, made a similar observation.  Fisher stated the U.S. can't ignore the effect that growing federal deficits will have on Treasury yields.  He noticed, similarly to Waldman, that "the markets...have bid up longer-term nominal rates, resulting in a yield curve that is historically steep." 

It seems clear that investors are already concerned about the risk of inflation or even flat-out default as a result of huge federal deficits.  The longer we wait to take action, the more interest rates will rise, which will further increase the cost of borrowing to the federal government.  We must get our fiscal house in order to avoid being entangled in this destructive cycle.